Free cash flow, explained

The formula

Free cash flow equals cash from operating activities minus capital expenditures. Operating cash flow is the first section of the cash flow statement. Capital expenditures are the cash spent on long-lived assets in the investing section: vehicles, equipment, property, major software.

Some owners subtract only the maintenance capex, the spending needed to keep the current business running, and treat growth capex separately. That is a fair refinement if you can tell the two apart. The plain version, all capex, is the one lenders and buyers use.

A worked example

A service business with $1,400,000 of revenue reports net income of $120,000 and operating cash flow of $118,000, after adding back $15,000 of depreciation and adjusting for a $20,000 rise in receivables, a $5,000 rise in inventory and an $8,000 rise in payables. It bought a truck for $45,000. Free cash flow is $118,000 minus $45,000, which is $73,000.

The free cash flow margin is free cash flow divided by revenue: $73,000 divided by $1,400,000, about 5.2%. Out of that $73,000 the business repaid $24,000 of loans and the owner drew $30,000, leaving $19,000 added to the bank. The profit was $120,000; the money the owner could actually take without weakening the business was closer to $73,000.

Free cash flow, profit and EBITDA

• Net income is profit after every accounting charge, including non-cash ones like depreciation. It does not count the cash tied up in receivables and inventory, or the cash spent on equipment.
• EBITDA adds interest, taxes, depreciation and amortization back to profit. It is a measure of operating earnings before the cost of the assets and the debt, which is exactly why it overstates the cash available to an owner who has both.
• Free cash flow counts the working capital and the capex. It is the strictest of the three and the closest to the money you can spend.
• When the three diverge, the cash flow statement says why: slow customers, inventory, or a year of heavy equipment purchases.

What a good number looks like

Positive, and growing with the business. Free cash flow margins vary widely by industry, from low single digits in distribution and construction to twenty percent and more in software and professional services, so the useful comparison is with your own prior periods. The test that matters for a small business is simpler than a benchmark: does free cash flow cover the loan payments and the owner draws you plan to take, with something left over? If it does not, the business is funding those from its cushion or from new borrowing, and the cash flow statement will show which.

A negative year is not always a warning. A business that bought a building or a fleet will show negative free cash flow in that year and higher operating cash flow in the ones that follow. Several negative years with no such purchase is the warning.

How to improve it

• Collect faster. Every day off your days sales outstanding is cash that was sitting with customers. Invoice the day the work is done and follow up on a schedule.
• Pay suppliers on their terms, not before. Early payment is a loan to your supplier unless they discount for it.
• Hold less inventory, or hold it for less time. Stock on the shelf is cash on the shelf.
• Separate the capex you need from the capex you want, and time the latter for the periods that can carry it.
• Price for the margin you need. Free cash flow problems that persist through good collections and lean inventory are usually pricing problems.

The part Liaison does

Most of free cash flow is collected, not calculated. Liaison reads your books and your inbox together and chases every open invoice in your voice, one reminder per customer matched to how each one usually pays. It matches payouts and deposits to the invoices they paid and flags the short-pays. And it answers, from the balance, the payouts on the way and the bills due, whether the next payroll, loan payment and owner draw are covered. The judgment about what to spend stays with you; the collecting and the counting do not have to.

Works with the tools you already run

Liaison connects to these and more with access you grant, and reads them together with the rest of your business. Each page shows what it reads and does in that tool.

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